Monthly Archives: April 2012

As aftershocks go, this will have stronger reverberations than even the original earthquake. Bo Xilai, the sacked Party boss of Chongqing, has been suspended from the Politburo and the Central Committee for suspected “serious violations of discipline”. His wife, Gu Kailai, has been placed under judicial investigation, along with a family employee, Zhang Xiaojun, in connection with the death of a British businessman and long-time family associate, Neil Heyward, who was found dead in a hotel room in the city last November. State media say police are now considering it to be a murder case.

Bo’s fall from grace has already sent tremors through Chinese politics in the run up to a leadership transition in which he had been expected to be promoted to the Party’s ruling inner sanctum, the Politburo standing committee. One of the Party’s rising leaders and, like his wife, a princeling, the charismatic and popular Bo’s sacking triggered–or was triggered by, it is hard to be sure in the opaque world of Party politicking at the highest level–the biggest political crisis since 1989 and the days of Tiananmen Square.

What comes next is anyone’s guess, or at least of anyone outside Zhongnanhai, the leaders’ compound in Beijing. There is a deep, if not clean factional divide between those who want the Party’s legitimacy to monopoly rule to be based on ideology derived from the mandate of Mao (in which camp Bo and his supporters fall), and those who wish to continue to base that legitimacy on the Party’s ability to go on delivering rising living standards for all Chinese, a course that now turns on scaling back the state’s role in the economy and giving the private sector more scope to expand. That raises, first, the question of how far can the Party scale back its economic control without yielding political control, and, second, how to deal with the challenge economic reform poses to many of the vested interests among the princelings and the military who derive their power, money and influence from the institutions and honeypots of a heavily state-directed economy.

Bo’s suspension from the Politburo means he has now lost all his key Party posts. As such it marks an important turn in that debate. How its consequences will shake out, and particularly if there will be a wider purge of the old guard — Zhou Yongkang, the Party’s security head and considered a Bo ally, may be the key figure to watch in this regard — takes a braver observer than this Bystander to hazard guesses at at this point. The political ground in Beijing is still shaking, and we are yet to see who else will be rattled.

Beijing’s creation of an industry association for rare-earths producers is best seen as an bulwark against the WTO complaint brought jointly by the U.S., the EU and Japan. This holds that China’s export quotas and other controls on rare-earths mining are not, as they purport to be, for environmental and sustainability reasons, but a pretext for protectionism as they drive up prices and favor end users that buy rare earths inside China, a provision intended to anchor in China manufacturers that are heavy users of rare earths, including high-tech, defense and green-technology firms. Beijing rejects the charge.

The new 155-member strong Association of China Rare Earth Industry, reporting to the Ministry of Industry and Information Technology, is charged with setting reasonable prices and properly handling trade disputes, as well as promoting the sustainable use of the minerals and environmental controls. The first two seem directly targeted at the WTO complaint, as were suggestions that China plans to abandon large-scale mining of the minerals.

Inflation is taking its time to decline, complicating policymakers’ options to deal with the overall slowing of China’s economy. March’s consumer price inflation number came in at 3.6% year-on-year, up from February’s 3.2%. February’s number was distorted by the early new year. The better benchmarks to look at are the 6.5% the CPI peaked at last July and the 3.8% it has averaged over the past quarter. March’s producer price index, which measure’s wholesale prices, fell slightly, also reinforcing the downward inflationary trend.

GDP growth for the first quarter, due to be announced on Friday, is expected to be reported at 8.4%, down from 8.9% in the fourth quarter of last year. The persistence of inflation means the central bank is unlikely to cut interest rates in response. It may cut banks’ capital reserve ratios to put more money in to the economy, but policymakers remain concerned about the threat of bad loans sitting on the banks’ books. That leaves either some sort of infrastructure stimulus spending, either formally or informally as it has started doing by easing the banks’ loan ceilings, despite the long term risks of adding yet more unsustainable debt, and refueling the property bubble authorities have worked so hard to cool, or hoping that growth in the U.S., or less likely Europe, picks up sufficiently to revive the fortunes of China’s hard-pressed exporters.

The persistent drought that has hit 13 provinces in southwest and central China is starting to have an adverse impact on farming, China’s drought-relief officials have indicated for the first time. The fear is that the spring planting on 4 million hectares of crop land is threatened by the shortage of water. Reservoirs, such as the one in the picture above, in Shilin County, Yunnan, have dried up, worsening China’s structural water shortages. Approaching 8 million people and 4.6 million head of livestock are short of drinking water, officials say, with the latest number suggesting the impact of the lack of rain is spreading with the drought now in its third year in some parts. Yunnan, Sichuan, Hebei, Shanxi and Gansu are worse affected. A widespread emergency relief effort is underway.

Footnote: The main cash crops in Yunnan, where the drought is most intense, are rice, maize and wheat. The province is also known for its tobacco and tea.

Prime Minister Wen Jiabao’s comment about breaking up what he called the monopoly of the four big state-owned banks is the tip of the iceberg in the fierce internal debate about the role of state-owned enterprises (SOEs) in China’s economy. That debate falls under the general but misleading rubric, financial reform. Yet it is not about privatizing the banks and the SOEs. Nor is it about replacing China’s model of state-driven capitalism with a free-market version. It is, instead, about two critical but related political questions. First, can the Party can still achieve its policy goals–of which the overriding one is maintaining its monopoly on political power–while controlling, through the state, a smaller share of economic output? Second, how far dare it go in risking loosening its political control by shrinking the state sector in order to let the private sector create more of the economic growth it needs to legitimize its monopoly on power?

This debate is going on against the backdrop of a leadership transition, always an unsettling time, and compounded by now being in conjunction with a critical transition in China’s economy. It is widely if not universally accepted among the top leadership, that China’s three decades of rapid fixed-investment and export-fueled growth are coming to their close. The country needs to rebalance its economy to get the sustainable growth that will let it slow the economy without coming to a full-stop, to defuse the debt bombs and deflate the asset bubbles caused by its investment-fueled growth, and to make the great leap forward to clear the middle-income trap and land as a developed economy.

How much structural change does that require, not just economically, but politically? More pointedly, how much further can economic reform go without political reform? It is a debate that has been off-limits, in public and much of the Party, since 1989, not least because it questions the trade-off of continuing rising living standards for living under of one-party rule (with the acceptance of the corruption and cronyism that involves rather than concern for the absence of Western-style civil rights and liberties.)

Hard-line statists and Mao revivalists, the so-called neo-Comms, maintain that the SOEs–and a firm stabilizing social hand–are a tried and trusted means to steer the economy through its present challenges, validated by the 2008 global economic crisis that laid low Western free-market economies. They provide the Party through the state with a mechanism for the administrative guidance of the economy. In the absence of market-based monetary policy tools, the big four banks sit at the center of this web of control dialing up or down the available supply of funds to their SOE customers as required to regulate investment levels.

Economic reformers fear This model are no longer fit for the new task at hand. The banks are inefficient allocators of capital, as the mounting piles of bad bank debt attest, while the SOEs crowd out the private sector, notably small and medium-sized enterprises that will be needed to create the productivity growth, jobs and innovation that China will need for the next stage of its economic development. With the inopportune political demise of Bao Xilai, the ex-boss of Chongqing and poster boy for the post-Maoist revivalists, putting the old guard on the back foot for now, the reformers are taking the opportunity to press their case. They are not calling for the abolition of SOEs, but saying that they need shaking up and scaling back, a case also argued by the Development Research Council/World Bank report on China in 2030, which we described as a “political manifesto disguised as an economic blueprint”.

China has more than 110,000 SOEs, but the 121 “national champions” in the strategically important “pillar industries” that report to the State Assets Supervision and Administration Commission (SASAC) and their big state-owed lenders (separately regulated) are the nexus of the country’s state-directed capitalism. They have a sway over the economy disproportionate to their number–5% of corporations but 40% of GDP at best guesses (nearer 50%, if thousands of small rural local-authority-controlled enterprises are included). In the pillar industries, which include both strategically important sectors and emerging technologies, SOEs control more than 90% of the assets. Their political and economic power have become so entwined at all levels that they have become deep redoubts of vested interest.

Consolidation, driven by merger and acquisition (the number of national champions, for example, has been reduced from 193 in 2003), now means that 40 or the 46 Chinese companies that rank among the world’s 500 largest corporations are SOEs. That only gives the biggest even more economic and political clout with which to defend the privileges they enjoy. The most topical of these is their ready and cheap access to loans from the big state-owned banks. Private companies are mostly forced to turn to unofficial sources and pay usurious interest rates–the issue Wen highlighted and the experiment in Wenzhou is seeking to address. SOEs get favorable tax treatment, and land and raw material subsidies. They are first choice when it comes to government procurement. As with bank loans, it keeps it all within the club. SOE staff have a powerful incentive to defend their turf, too: salaries are five times the average in the non-state sector. The benefits are better, too, and the political access unrivaled.

With the caveat that SOEs as a group are no more monolithic than any other large group of companies across multiple industries, privilege has not turned into performance. Qiao Liu of the University of Hong Kong has calculated that the average return on equity for SOEs to be 4%, compared to 14% for unlisted private firms. But there is a great range among the profitability of SOEs: those in industries dominated by the state are highly profitable; those in sectors with high levels of competition, not so. (Gao Xu, while working as an economist at the World Bank’s Beijing office, made a detailed analysis of SOE performance by industrial sector.)

China’s WTO membership committed Beijing not to interfere in the commercial decisions of SOEs, but as top executives are appointed by the Party, SOEs tend to be politically self-regulating. They take it as a patriotic duty to fall in behind the goals of five-year plans. That is not to say they are docile handmaidens. As players in the patchwork of power and patronage that rules China, they have their own agendas to promote and turf to defend, as well as those of factional interests allied to them. One reason that the pace of financial reform has been so glacial in recent years is that it is seen by SOEs as a threat to their position.

That has not prevented reformers’ long-standing efforts to at least improve the governance of SOEs, by structuring them less like ministry departments and more like shareholder corporations, even if government at some level is the sole or controlling shareholder. The creation of SASAC in 2003 was an attempt to provide external institutional oversight that would promote more professional management of SOEs. More recently, foreign investors have been brought in via offshore listings of SOE subsidiaries in the hope that international management best practice will arrive along with new equity. The biggest SOEs have been pushed overseas in part to experience business in competitive, rule-bound markets that China will, eventually, have to create at home if it is to have balanced growth. This experience has also provided them with a stark lesson in how the rest of the world assumes that even the most commercially-oriented SOEs are an arm of government, as companies like Chinalco and Huawei have recently found out.

Loosening the ties that bind SOEs to state and Party is necessary if China is to give the private sector more scope to drive the growth the county needs to move to the next phase of its development. This goes far beyond just making more credit available to small and medium-sized enterprises, a welcome start though that would be for China’s entrepreneurs. However, socialism with Chinese characteristics, or even capitalism with Chinese characteristics, means that state-owned companies will continue to play a large role in the economy. Privatization, as happened in the former Soviet Union and Eastern Europe, is not on the cards. It is a matter of how small is large.

For foreign companies and investors, some sectors will become more open to them as they will to private Chinese companies. Others, strategically important, will remain off-limits not just to foreigners but domestic private firms as well. SOEs will strongly resist being reined in, as they have successfully done before. They may find the fight tougher this time. The political stakes are certainly higher as the Party confronts its defining dilemma: how to loosen the ties that bind without endangering either economic or, worse, political stability.

Every leading nation’s big banks wield political clout. China’s, being state-owned and run by big political players in their own right, sit more easily at the center of power than most. They see it as their rightful place. Both they and the government see their role as providing conduits of national policy. Administrative guidance to the banks sets the course for their customers in business and industry in the cause of economic growth, be that slowing inflation, deflating bubbles or stimulating growth. So when Prime Minister Wen Jiabao says the big banks’ monopoly needs to be broken as they make easy money for themselves while denying loans to cash-strapped small and medium-sized enterprises he needs to be assured that he is safe in rattling such powerful cages and that the need to do so is urgent.

In the words of the song, breaking up is hard to do. Yet Wen’s words at least get the idea on the table and add to the determined thrust by the economic reformers to use the leadership transition now underway to revitalize near moribund financial reform. Wen again pointed to the pilot scheme in Wenzhou to create alternative financing channels for small and medium-sized enterprises in the city that have hitherto been forced into the usurious shadow banking system. This is being seen by some as an experiment that if successful will be expanded more broadly as a necessary underpinning of the rebalancing of the economy towards domestic demand.

The prime minister’s words came as regulators further opened capital markets to foreign investors. That, though, is politically easier to do than taking on the big banks, large redoubts of vested interests that they are. The opportunity to do so may lie in the slowing economy turning more bank loans sour. Government has had to step in once before to clean up the state-owned banks’ balance sheets. The price for doing so again could be more conditional. And might it even include the big banks improving their rudimentary credit-risk analysis? A bit more competition wouldn’t go amiss in that regard, while plenty of entrepreneurs would be happy to have their creditworthiness judged on their business prospects rather than their political connections.

The official purchasing managers’ index (PMI) for March came in at 53.1, higher than expected and the highest monthly measure of factory activity in a year. Yet the flash (preliminary) HSBC PMI for March, which is weighted towards export-dependent small- and medium-sized manufacturers, fell for the fifth consecutive month, to 48.1. Any number below 50 signals contraction; above, expansion. The two numbers reflect the broader division of opinion over to what extent China’s economy is slowing and the likely policy reaction. Weak demand in China’s export markets and the government’s success in cooling the property markets are the main reasons the economy is slowing. With the central bank reiterating that monetary policy will remain “prudent” and inflation falling but still persistent, we still expect government to support manufacturers through measured stimulus spending on transport and infrastructure projects.